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What’s our gold standard?

March 27, 2009 1:12 pmMarch 27, 2009 1:12 pm

I’ve just reread Eichengreen and Temin, The Gold Standard and the Great Depression, which does a great job of showing how the “gold mentality” — what they call mentalite, with an accent — paralyzed policymakers. (The longer-form version, with more personal color, is Liaquat Ahamad’s Lords of Finance.)

What E&T show is that circa 1930 key decision-makers had spent so many years equating adherence to gold not just with prosperity, but with morality, decency, civilization itself, that they couldn’t even contemplate breaking with that orthodoxy — even in the face of total catastrophe.

I think we’re more flexible now. But my sense is that the mystique of finance is playing a somewhat similar role.

It is NOT just finance. When the govt intervenes to buy these assets, it matters. and again:

The subsidy is small!!!!! The STOCHASTIC DISCOUNT FACTOR in the good state where they get 20 is very low, and the SDF where they lose 19.5 is very high. The investors’ indifference point between states would be more like 25 and 5; hence the subsidy is nowhere near 30%.

If someone wanted to direct $1T of govt money to buy toxic assets at somewhere near market value, he could not have devised a better plan.

Another way to say this: The toxic asset performance should be procyclical across future states. Hence, the levered beta on the private investor’s equity is like 8.0!! They are not going to overpay by much for the assets! Your two state example misses their very risky position.

A third way to say this is to think about modigliani-miller, which only partially applies here (because the debt rate is below market) but this builds one’s intuition about the equity position – equity will always have high expected value and variance. If the asset drops in value by only 15%, the investor loses everything!! Your analysis without risk misses a first-order effect.

If someone wanted to direct $1T of govt money to buy toxic assets at somewhere near market value, he could not have devised a better plan, with a small implicit subsidy to motivate people. I have agreed with almost everything you’ve written for years, but you JUMPED to a conclusion about this being another handout – perhaps because you were so primed-up to see a handout in whatever Geithner did. (The only real problem here is the potential for abuse by someone who also has a stake in the bank from which they are buying, and directing the government to buy, the asset – overpay by 3 cents to get the government to overpay by 97 cents to the bank of your choice).

It seems as if the Obama administration is trying to reinflate all the bubbles that got us into this situation. The point is not whether the Bush administration was worse, but whether we really can’t think of a better and more sustainable approach than trying to reinflate the housing bubble and all the financial bubbles that have come with it. Larry Summers seems to want to go back to about 1999 and just do it all over again.

Our equivalent is the worship of derivatives, especially the credit default swaps. Just as maintaining the gold standard forced the depression-era national banks into destructive deflationary policies, paying off derivatives that never should have been allowed to exist is forcing the current national banks into wasteful giveaway and encouraging zombiefication.

O’Hare, uh? Wise choice to be getting out and about. But before you leave, I have a few questions. Why was it so hard for you not to see David Li was a mole. How come you didn’t make a racket about the CDS casino a long, long time ago? What exactly is your job? Don’t be alarmed, these are only academic questions now. Gotta go now. I have my own plans to make. But geeze, isn’t that Obama a work of art?

Speaking of Liaquat Ahamad’s Lords of Finance, I loved the paragraphs on the Senate and House hearings on brokers’ loans in early to mid-1928: “…overall a spectacle somehow both embarrassing and uplifting. It was painful to watch the good senators flailing around trying to understand the workings of a complicated financial system and hurling foolish questions at the expert witnesses. But there was also something admirable as they voiced the outrage of the common man at the absurdities of Wall Street.”

Just guessing, but is the U.S. Dollar itself the de-facto gold standard now? It seems that no amount of fiscal irresponsibility will budge its value. Its buoyancy keeps import prices consistently low, and makes it difficult for Americans to compete in world markets. I’ll vote for $.

Geithner’s premis is that… with some skin in the game, managers bidding on the assets will be careful how much they bid. Sadly this is fatally flawed.

With only a little bit of skin in (this side of) the game, but a whole lot more in the other side of the game, the managers are highly motivated to over bid.

Conversely, the geither plan could work if only managers who could not possibly benefit by over bidding were selected. Of course… this is an impossible dream…. because even if those putting up 30-70 billion dollars did not have a vested interest in inflating the value of mortgage backed securities directly themselves (highly improbable)…. it is easy to see that some form of corruption in which payments circulate back to these managers is eminently possible. And with the amount of money involved…. inevitable.

In this morning’s column, Paul Krugman implies that securitized credit instruments are unnecessary. Yet, I hear claims that as much as 2/3rds of the country’s credit is done by these instruments. Can someone explain to me how we can replace them with other sounder instruments that charge lower fees? If not, can they be regulated effectively to control risk and excessive fee charges?

Your ancient ancestor describes the collapse of the Mayan Civilization:

Says Krugmanetlan: Then some farmers discovered that they could sell the same assurances back to the priests, with the guarantee that if in fact it didn’t rain, contrary to what the priests assured, they would pay the priests a guaranteed portion of their crop with which to offset the losses on the assurances.

The post looks like half of a contrast: Suggesting that the orthodoxy of the 1930’s was foolishly tied to the gold standard, and that today’s isn’t tied to … something? The only thing that seems to fill the blank is the notion of a credit-based economy.

Fundamentally it seems like the government is stuck between a rock (keeping interest rates low for stimulus) and a hard place (increasing interest rates for debt relief).

I’m ignorant, but aside from outright obligation manipulation, or something similarly gross, there doesn’t seem to be a whole lot of analogue to messing with the gold standard.

I was hoping to see a link in your column today to Simon Johnson and James Kwak’s excellent Atlantic article, The Quiet Coup (//www.theatlantic.com/doc/200905/imf-advice). It seems like a very good accompaniment piece to your column.

Circa 2009 key decision-makers had spent so many years equating adherence to central banking not just with booms and busts of the business cycle, but with the immorality of easy money, the indecency of inflation, and the criminal destructiveness of civilization itself, they couldn’t even contemplate breaking with that orthodoxy — for fear they may have to actually work, even in the face of total catastrophe.

Art in comment #1 overestimates the value of losses in the bad state because he thinks the investors will pay them. They won’t, because they’ll be bailed out again or go bankrupt.

Speaking of Modigliani-Miller, it does apply here to the extent that the equity of these investors (or the future income stream of their employees / traders) is a call option on the assets of the investment firm. In other words, the downside is limited. Art overlooked this point.

the problem with the toxic asset plan is the inability to recognize that the private investors are purchasing a put option for very little. Like all good option traders the real money will not be made on the actual option but trading around it. Unfortunately, the tax payer is not going to be in on those trades. Put another way the person who “buys and holds” a high volatility option is almost always going to lose money.

All the criticism of the plan could be answered if Geithner was willing to testify under oath – that there was no way in which the private investors collectively could make money and the tax payer lose money. That is is selling point- if the private investors make money the tax payer makes money and it simply is not true. If he is lying about that what else is he lying about.

Professor Krugman’s comment about 1930’s decision-makers “equating adherence to gold not just with prosperity, but with morality, decency, civilization itself” is no exaggeration. The economic historian Karl Polanyi in his classic book “The Great Transformation” noted thantmany of the weaker European economies (e.g. Greece, Eastern Europe) “literally starved themselves to reach the golden shores.” The triumph of ideology over sense rides again!

I think the mindset we must break to break through to the financial innovation we need is not just the mystique of finance, although we are surely going to have to recognize that many Masters of the Universe types were actually more aggressive and amoral than smart.

But, to me, the real key is moving toward the recognition of the economic value of environmental services. In a time of post-peak oil, the old formula that assumed an energy price independent of environmental considerations just doesn’t work to properly price risk– risk to the planet, as well as risk to the individual. These considerations can’t remain exogenous to the financial world and its calculations, or we risk total catastrophe.

Our equivalent today could very well be inflation targeting which almost all mainstream economists strongly believe in. What probably makes the situation even worse is that the educational systems in economics are much more homogenous today than they have been in the past; there is hardly any room for different schools of thought. There is a possibility that this homogenization could make it more difficult to evaluate if a theory is right or wrong since everyone already believes it is correct.

[OT] On the rare occasions when I can convince myself that I understand most of them, I appreciate the “On Accounting” columns in the FT. Yesterday’s was the only thing I’ve seen regarding Congress leaning on FASB to nix mark to market. Maybe some comment on this issue would be appreciated by more than me.